Status: 27.10.2022 5:00 a.m
In the fight against inflation, the ECB will raise the key interest rate sharply again today. But can it really put a stop to the rapidly rising consumer prices?
The time of the XXL interest rate hikes in the euro area is not over yet. Economists are convinced: The European Central Bank (ECB) is likely to decide today to raise its key interest rate again by 0.75 percentage points. The main refinancing rate would then rise to 2.0 percent, and the interest rate on deposits, which is important for savers, would rise accordingly to 1.5 percent.
High core inflation increases pressure on ECB
“As the ECB is lagging behind in the tightening cycle, it needs to keep acting fast and hard,” said Franck Dixmier, global bond chief at asset manager AlllianzGI. Pressure on the monetary authorities comes from the record high inflation rates in the euro area.
In the euro zone, the inflation rate rose by 9.9 percent in September to the highest level since monetary union came into being. The core inflation rate, i.e. the development of consumer prices after factoring out volatile energy and food prices, was 4.8 percent compared to the previous year.
Inflation comes from the supply side
The theory says that inflation can be combated by raising key interest rates, as this makes saving more attractive, consumers consume less and prices go down. But be careful: This mechanism only works if it is demand-induced inflation. With this form of inflation, prices rise because consumers are so keen to consume and spend so much money.
However, the currently rising consumer prices are rather the result of changes on the supply side; Economists speak of supply-induced inflation. Inflation is therefore primarily due to companies and their pricing.
High raw material costs and supply chain problems
The German Economic Institute (IW) is now also pointing this out in a recent study available to the Reuters news agency: According to this, more than half (51.9 percent) of the basket of goods used to calculate the inflation rate is from goods influenced by the supply side. Their price increases are due to increased energy and raw material costs and interrupted supply chains.
We are therefore dealing with cost inflation, a special form of supply-side inflation. Naturally, however, the ECB can hardly counteract this type of inflation, since its policy is aimed more at the demand side. “Monetary policy is currently powerless against a large part of the current inflation,” conclude the IW authors Markus Demary and Jonas Zdrzalek.
Relaxation in gas prices and supply chains
In fact, there are currently signs of some easing in the inflation drivers of energy costs and supply chains – without any action on the part of the ECB. For example, the price of gas in Europe recently fell below 100 euros again for the first time and thus fell to its lowest level in four months. According to analysts, the reason for this is the mild autumn throughout Europe and the well-stocked gas storage facilities.
Inflationary pressures are also easing on the supply chain side. This is shown by a look at the Baltic Dry Index, which describes the demand for bulk goods transport capacities on the world’s oceans. A shipping container currently costs around $3,400. “Previous prices from the first half of the year of more than 10,000 US dollars are a long way off. Container prices at this level speak for a resolution of the supply chain problem,” emphasizes market expert Robert Rethfeld from Wellenreiter-Invest.
Not least against the background of a clearly negative base effect – massive leaps in inflation were recorded in spring 2022 – for the coming spring, Rethfeld expects euro area inflation rates to fall sharply towards the four percent mark.
ECB has to fear for credibility
The question remains: If the ECB can firstly have little influence on supply-induced inflation and secondly inflation rates could fall soon anyway, why are the currency watchdogs around Christine Lagarde trying to take countermeasures at all?
It’s also about credibility. The ECB needs to regain control of inflation expectations. Because there is a real danger that market participants will perceive the currently high inflation rates as the new normal and price them in. Experts warn of a wage-price spiral. Wage negotiations have only just begun in an extremely tense social climate across the eurozone.
Risk factor imported inflation
Last but not least, with their monetary policy, the currency watchdogs have a clear influence on a sub-area of inflation: namely on the so-called imported inflation. Because it is also the weak euro that is causing prices to rise in this country. Commodities such as oil are quoted in dollars. If the euro falls against the dollar, euro area buyers will have to pay more for the same amount of oil, all other things being equal.
However, rising key interest rates in the euro area make investments in the euro area more attractive, which in turn increases demand for the euro and thus the euro exchange rate. The extent to which the ECB can influence this with its monetary policy was recently observed on the foreign exchange market. The euro/dollar exchange rate has increased by around 1.6 percent since the beginning of the week. Market observers speak of a classic “anticipation effect”: Investors anticipate the impending increase in key interest rates.
Aggressive interest rate hikes coming to an end?
The ECB is therefore well advised not to sit back and do at least try to regain some measure of control over inflation. However, in view of falling energy prices and simultaneously growing economic risks, the ECB is unlikely to maintain its more aggressive stance for much longer. Especially since the Fed, a pioneer, could soon begin to shift the focus from fighting inflation to fighting the recession.